Quality Growth Boutique
Global equities specialists since 1984. We provide a boutique investment experience for institutional and intermediary clients around the world.
Although the end was already inevitable, the ongoing trade war and the eroding U.S.-China relationship have been a catalyst for making it less attractive for Chinese companies to seek a public listing in the United States. While not all Chinese ADRs will go away entirely, certainly the U.S. markets will no longer be the default venue for Chinese companies to raise capital. The Chinese government is finally making good on promises to open up domestic markets to foreign investors. Additionally, Hong Kong and China are taking steps to make local listings more attractive, especially to high-tech start-ups.
There are many foreign companies listed on U.S. exchanges, but Chinese companies, which account for a market capitalization on U.S. stock exchanges of more than one trillion dollars, are an anomaly. Of more than 400 fully sponsored ADRs listed on the NYSE and the NASDAQ, approximately 150 are Chinese companies. There are multiple reasons this unusual situation has evolved over the last two decades. In the beginning, around 1999, one of the primary arguments to list companies in the U.S. was the lack of equity financing in China, alongside the status associated with a U.S. listing, as well as greater openness for high-tech companies to go public before they are profitable. Moreover, the NASDAQ permits dual-class shareholder structures, which allows a founder to maintain majority control even with less than 50% economic interest. However, Tencent’s success, despite listing in Hong Kong, tends to weaken any arguments that raising equity in the U.S. was necessary.
Enabling this trend of U.S. listings was a residual outcome of the Enron scandal. Enron had found a loophole to hide debt off the balance sheet by warehousing the debt in Special Purpose Vehicles (SPVs). While Enron owned only a very small percent of the equity, a legal contract between Enron and the SPV held Enron liable for all of the liabilities in the SPV. An outcome of this event was the development of a new financial accounting rule, FASB 46, which dictates that, even if a company does not have an equity stake in a subsidiary, they are still required to consolidate any legally binding financial obligations they have with the entity.
The Chinese government had long held that foreigners could not have controlling stakes in industries deemed high-tech. Through the unanticipated use of FASB 46, the Variable Interest Entity (VIE) was born. This allowed Chinese companies to bypass Chinese ownership restrictions while allowing U.S. investors exposure to the economic benefits of more exciting and faster growing parts of the Chinese economy, albeit without any controlling interest. Unfortunately, this also meant that the average domestic Chinese investor was deprived of the opportunity to participate in and benefit financially from this growth.
Recent changes to the Hong Kong exchange listing requirements has opened the door for Chinese companies, especially internet services companies, to move back closer to home. The major change is that, similar to the U.S. NASDAQ exchange, the Hong Kong exchange in certain instances now allows for dual-class shareholding structures. Companies with these types of shareholding structures currently do not qualify for the Shanghai-Hong Kong Stock Connect. However, given the trajectory of change and some more recent examples of exceptions given to Xaiomi and Meituan to participate in the connect program, it is more likely that the more recent additions to the Hong Kong market, such as Alibaba, Netease and JD.com, eventually will be directly available to mainland investors.
The opportunity for companies to move to Hong Kong without having to make significant changes to their shareholding structures couldn't have come at a better time. Due to the growing U.S. frustration with the Chinese government’s unwillingness to play by the rules of international norms, there has been increasing bipartisan support towards requiring U.S.-listed Chinese companies to comply with disclosure requirements. Any foreign company that is listed on a U.S. exchange is required to have an auditor, which is under the jurisdiction of Public Company Accounting Oversight Board (PCAOB). The Chinese government thus far has refused to allow Chinese auditors, who audit these U.S.-listed companies, to be inspected by the PCAOB. Up to now, U.S. regulators have allowed this non-compliance to exist. However, pending legislation in the U.S. Congress will require compliance or ultimately force these Chinese companies to delist from U.S. stock exchanges within three years, or possibly sooner. All signs are that this legislation will easily pass.
With the recently announced IPO of Ant Group, the Fintech business being spun out of Alibaba, there is another positive step towards greater mainland investor access to a growing set of higher quality, faster growing businesses. Ant Group has filed to list on both the Hong Kong Exchange and the relatively new Shanghai Stock Exchange Science and Technology Innovation Board (STAR board for short). After the failed ChiNext exchange launched in 2009, the STAR board is a second attempt at creating a Chinese equivalent to the NASDAQ. Over the years, several countries have attempted to replicate the success of the NASDAQ in attracting and raising capital for earlier stage, high-tech businesses. These attempts, however, have had mixed results. While lowering listing requirements makes it easier for start-ups to raise capital, it also has the tendency to come with a greater risk of fraud. Ant Group’s listing on the STAR exchange will certainly go a long way to legitimize and possibly help STAR avoid the fate of ChiNext.
While this is good news for mainland investors, what this means for investors in the U.S. or Hong Kong depends on how these securities are structured. For example, the Alibaba listing in Hong Kong is entirely fungible with the U.S. ADR—meaning, for a nominal fee, shares can be converted. This should help keep mispricing between the two exchanges to a minimum. Over time, if Chinese companies eventually decide to delist from the U.S., it will certainly be a negative to smaller retail investors. However, all is not lost. Foreign companies can still potentially trade on the Over-The-Counter (OTC) market without having to comply with U.S. auditing requirements. Tencent, for example, trades in the U.S. on the OTC market and trades a couple hundred million U.S. dollars a day on average. SMIC, which delisted from the NYSE last year, still trades on the OTC market.
Investors should be aware that OTC-traded companies do not have to comply with any U.S. accounting requirements. Although companies like Tencent, Alibaba or Netease already have high corporate governance standards and likely do not pose any additional risk to investors in the event of a U.S. or Hong Kong delisting, the one risk that would remain, albeit low, is that of the VIE structure. Even if a company with a VIE structure moves its listing to Hong Kong or mainland China, there is a risk that at some point the Chinese government finds the arrangement to be detrimental to national interests. Such a decision would likely have a high financial impact to investors.
In the short run, there has been hope that mainland investors will have a positive impact on earnings multiples but so far results have been mixed. Domestic Chinese exchanges are predominantly driven by short-term retail investors who tend to focus less on valuation. The growing openness to foreign investors, together with the growing number of high-tech businesses with strong corporate governance standards, will help accelerate the maturity of market behavior and create a base of more long-term focused investors.